Why Some Say Cramdowns Good for Banks

Much of the banking industry continues to resist mortgage bankruptcy reform, but some observers are arguing that bankers would actually see a benefit if the legislation passed.

Legislation letting bankruptcy judges rewrite mortgage terms would give servicers justification to pursue principal reductions  something investors holding loans have long resisted. It also would address one of the issues prolonging the housing downturn: Half of all borrowers who receive loan modifications end up defaulting again, leading to more of the foreclosed properties that have flooded the market.

Rod Dubitsky, the head of Credit Suisse Group's ABS research division, said bankruptcy reform will be "a net positive" for the industry, because it could reduce foreclosures by 20%.

"Bankruptcy cramdown is expected to increase principal reduction modifications," he wrote in a report issued last week. "For the many borrowers who are close to the edge, the new bankruptcy law would give them both equity and payment relief."

In a filing under Chapter 13 of the federal Bankruptcy Code, the mortgage would get reduced to the property's current net present value, and the reduction would be treated as an unsecured loan that gets paid back over three to five years.

The amount of the unsecured claim that can be recovered in bankruptcy is based on the borrower's disposable income and other claims that get discharged in bankruptcy.

Dubitsky said the combination of "close supervision by the bankruptcy trustee on borrowers' income and expenses for five years" and making the cramdown benefit contingent on completion of the bankruptcy plan "will help reduce incentives for borrowers to file."

Still, the legislation would hurt mortgage bondholders, second-lien investors and lenders, and card and auto lenders, which would be forced to accept the same repayment plans as mortgage lenders, he said.

The latest version of the legislation would allow lenders to share in the appreciation of a home's value for up to four years, and it would narrow the playing field of eligible borrowers. Under an agreement legislators struck last month with Citigroup, a borrower would have to contact a lender to seek a modification at least 10 days before filing under Chapter 13.

Lawyers and judges are countering the banking industry's claims that courts would be overwhelmed by bankruptcy applications. They say that there is plenty of excess capacity, and that the judicial system has several mechanisms to transfer resources to districts that become overwhelmed by an increase in filings.

Judge Christopher Klein, the chief bankruptcy judge of the U.S. Bankruptcy Court for the Eastern District of California, said the courts are "perfectly well prepared" for an increase in filings.

In the fiscal year that ended Sept. 30, California ranked 21st with 3.18 bankruptcy filings for every 1,000 people. Tennessee had the highest rate (7.27), followed by Nevada (6.39) and Georgia (5.96).

"I see nothing that is going to cause significant trouble for the bankruptcy system," Klein said in an interview Friday.

John Rao, an attorney at the National Consumer Law Center, said the industry "forced the legislation upon themselves," because lenders agreed to modify loans voluntarily and ran into roadblocks from servicers and investors.

"When servicers are servicing a pool of loans for a trust, they are reluctant to do anything, particularly reducing principal, even if it's in the best interest of everyone and will reduce their costs in the long run," Rao said. "All the data shows that most modifications don't really benefit the homeowner, and a lot them increase the monthly payment. So at what point do legislators decide they've given the industry enough time?"

According to Dubitsky, after the legislation is passed, filings under Chapter 13 could result in higher monthly payments for investors, because the secured portion of the overall debt bears a market interest rate, and the borrower has to pay back some amount of the unsecured debt."This means that many borrowers who can service the full mortgage over 30 years can reduce their payments merely because the crammed portion has to be paid back over five years," he wrote.

Henry Sommer, a past president of the National Association of Consumer Bankruptcy Attorneys, said the legislation would result in more successful modifications and could reduce bankruptcy filings.

"This puts the ball in the lender's court, because they have to offer something" to the borrower, he said. "They will have more performing loans and a lot fewer foreclosures."

How a bankruptcy court determines a property's net present value also has become a contentious issue. Before 1994, when the code was changed to eliminate rewriting of mortgages, judges routinely handled the property valuations as they do now for commercial properties.

"The system did not collapse before 1994," Klein said. "Valuation occurs every day in the courts of this country. It's a well-understood procedure used with great regularity."Lawyers typically agree on a net present value based on evidence from appraisers and comparable sales data, so not all valuations would be decided by judges, he said.

"Valuations often are skewed slightly in favor of creditors, so the creditor could wind up with a performing mortgage that gets pushed out as much as 40 years," Judge Klein said. "This kind of predictability is especially important to the secondary market."

Adam Levitin, an associate professor at Georgetown University Law Center, questioned industry claims that bankruptcy reform would cause mortgage rates to rise and further restrict lending.

"Because lenders face smaller losses from bankruptcy modification than from foreclosure, the market is unlikely to price against bankruptcy modification," Levitin said. "Bankruptcy modification offers immediate relief, solves the market problems created by securitization, addresses both problems of payment reset shock and negative equity, screens out speculators, spreads burdens between borrowers and lenders, and avoids both the costs and moral hazard of a government bailout."

Dubitsky said filing under Chapter 13 "is a fairly onerous procedure, and many borrowers may choose foreclosure rather than bankruptcy."

Since many delinquent borrowers cannot pay their mortgage anyway, the losses that lenders would suffer "would not seem to be any higher under the bankruptcy proposal and may in fact be lower," he said. "We don't believe the bankruptcy reform will materially impact the pricing or availability of mortgage credit."

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